Are the Bond Vigilantes Wrong?

Imagine you’re U.S. President Barack Obama, U.K. Prime Minister Gordon Brown or Greece’s George Papandreou. What should be your top economic priority? Putting in place a sustainable economic recovery or paying off your heavy debts? That’s a key question roiling economists right now.

For months, investors like bond giant Pacific Investment Management Co., or Pimco, have held the upper hand in this debate, putting pressure on the U.S. and U.K. governments by highlighting the dangers of running up a huge debt tab. Here’s the argument of such “bond vigilantes” in a nutshell: Heavily-indebted countries like the U.S. and Britain need to move swiftly to reduce yawning budget deficits. If they don’t, they risk another financial crisis, perhaps sparked by rampant inflation and a sinking currency. (Why are bond investors in particular worried? Answer: If there’s an outbreak of inflation, that, in turn, clobbers prices of investments offering a fixed income, like government bonds. In short, these investors don’t want to lose money.)

It’s not just investors. Economists like Harvard University’s Kenneth Rogoff also worry that current U.S. debt levels could push the country toward a tipping point where interest rates could soar and the value of the dollar could plunge. Keeping bond investors happy is important: If they don’t buy U.S. government bonds, the U.S.’s cost of borrowing shoots higher.

Still, it appears the bond vigilantes are starting to face something of a backlash. In Britain, the National Institute of Economic and Social Research is arguing that Britain shouldn’t move to cut spending before the U.K. economy stabilizes. (Britain only managed to grow 0.1% in the fourth quarter of last year.) The size of future spending cuts has already become a major political issue in Britain, which faces elections that must be held before June.

There are even economists who think the fiscally-challenged Greeks shouldn’t be cutting that much: Columbia University professor Joseph Stiglitz said yesterday that Greece’s recent plan to slash its budget deficit – which got a green light from European officials today – could end up stifling the country’s growth. Slower economic growth, in turn, would crimp tax revenues and end up increasing the budget deficit. And don’t forget the International Monetary Fund, which has been warning for months that governments shouldn’t move too quickly to cut spending lest that impede the economic recovery.

It’s not one or the other, of course, but governments at some point will have to set their priorities. Britain and the U.S. should, in theory, have a relatively easier time handling heavy debts without spooking the market. That gives them wiggle room. But for a country like Greece – which has less international credibility, faces years of sluggish economic growth and has trouble even collecting taxes – the decision may be murkier.

Comments (4 of 4)

I see, WSJ is turning into State Socialist supporter...like The Economist, Financial Times...

10:50 am February 3, 2010

Joe Chro wrote :

Unfortunately, since we have an undisciplined amateur for President, we may become more and more dependent on the whims of foreign investors. We, the American voters, need to continue sending the radical control freaks in Washington a message - and eventually vote them out. If we don't, the bond vigilantes could make life for our nation really miserable -- all thanks to this radical and his cronies.

9:16 am February 3, 2010

michael wrote :

Whoever said that government spending taxpayer money to stimulate an economy is better than the private sector creating jobs is just plain wrong. All this government money creating debt is a total waste of taxpayer resources and will end up hobbling a country's ability to fund credible programs.

9:15 am February 3, 2010

Anonymous wrote :

This is the same question facing every business. Unfortunately business just cant issue debt forever like government. Business has already dramtically cut spending and is, in fact, reducing its debt, preparing for when the economy picks up. When that happens business will be in a position to boom. Government is fat and bloated and will remain that way.

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